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Leveraging Your Profits

By Mark Munday

My April article was all about the difference between Fixed Costs and Variable Costs. You can review the article at the Small Business website. This month, we use the costing distinction to understand exactly what happens to Profits when Sales go up or down.

A clear understanding of how a change in sales impacts on profitability, is essential for good financial management of your business. Knowing how Profits will respond to an increase (or decrease) in Sales, supports using an informed and balanced business strategy to improve financial results.

Increasing Sales while Fixed Costs (i.e. rent, salaries, interest etc) stay the same, causes an even bigger increase in Profits. The magnitude of this multiplier effect is what is called the Degree of Operating Leverage (DOL) in the business. It indicates how sensitive profits are to a change in sales.

Your DOL depends on the relationship between Fixed Costs and Variable Costs (raw materials, components, hourly paid labour etc.). The higher your fixed costs are, the greater the impact a change in sales has on profits.

If that all sounds like gobbledygook to you, consider these examples. Companies A and B have the same level of sales and profits. But different relationships between fixed and variable costs causes the DOL, or the response of profits to changing sales, to differ widely :

 		Company A	Company B
 Sales		$100,000	$100,000
 Variable Costs	$ 60,000	$ 20,000
 Fixed Costs	$ 20,000	$ 60,000
 Net Profit	$ 20,000	$ 20,000
Now let's see what happens when these two companies increase sales by 10%. Remember that Variable Costs will also increase by 10% (they are volume driven costs). But Fixed Costs will stay the same.

 		Company A	Company B
 Sales		$110,000	$110,000
 Variable Costs	$ 66,000	$ 22,000
 Fixed Costs	$ 20,000	$ 60,000
 Net Profit	$ 24,000	$ 28,000

% increase 20% 40% DOL 2.0 4.0

Company B's high level of fixed costs means that a 10% increase in Sales caused a 40% increase in profit. Company A, on the other hand, enjoyed a much smaller increase in profits. Clearly, increasing sales has a much more powerful leveraging effect on profits in company B than it does in company A.

To calculate the Degree Of Operating Leverage for your business, use this formula :

DOL = (Sales - Variable Costs)/(Sales - Total Costs)

Remember to treat your living costs as a fixed cost. It is the minimum amount that you have to take out of the business, no matter how little revenue is generated.

So what does all this mean for your small-business?

Well, if your operating leverage is very high, you can catapult profitability by using more productive resources in your business. Employing more people to increase production spreads the high level of Fixed Cost over a much bigger volume. Unit total-cost comes down and the business becomes a lot more profitable.

A high level of operating leverage also means that you are exposed to more risk. If sales decline suddenly, profits will fall a lot faster and a lot further. The airline industry is a typical example of this happening. High operating leverage has meant that declining numbers of passengers has caused many airlines to go bust in recent years.

If, on the other hand, your business has relatively low fixed costs but high variable costs, a different strategy will produce better results. Low operating leverage suggests that you need to look for opportunities to add more value for your customers. It will mean that you will be able to increase your prices, and profits will take off. And you probably need to improve productivity.

Using an admin assistant or a secretarial service to do non productive work could substantially increases productivity and cause profits to soar. Improving efficiency through increased mechanization or other methods, can also give profits a big boost.

As a Business Strategist and Coach, Mark works with business owners to help them achieve their business goals. His powerful strategic planning and implementation techniques produce stunning results for clients. Go to for details.

For expert assistance with creating and implementing a winning business strategy, phone him on (09)476-5510 or email him.

Mark recently released a unique and revolutionary system for building your business into what you really want it to become.

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